September 18, 2011
In his celebrated essay “The Quagmire Myth and the Stalemate Machine”, published in 1972, Daniel Ellsberg drew out the lesson regarding the Vietnam war that came out of the 8,000 pages of the Pentagon Papers, which he had secretly copied a few years earlier. It was simply this: policymakers acted without illusion. At every juncture they made the minimum commitments necessary to avoid imminent disaster – offering optimistic rhetoric, but never taking the steps that even they believed could offer the prospect of decisive victory. They were tragically caught in a kind of no-man’s-land – unable to reverse a course to which they had committed so much, but also unable to generate the political will to take forward steps that gave any realistic prospect of success. Ultimately, after years of needless suffering, their policy collapsed around them.
Much the same process has played out in Europe over the past two years. At every stage of this process, from the first signs of trouble in Greece, to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the stalemate machine. They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.
The process has taken its toll on policymakers’ credibility. As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 per cent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view on the latter point is a reasonable one. After the spectacle of European bank stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators’ assertions about the solvency of certain key financial institutions?
A continuation of the grudging incrementalism of the past two years now risks catastrophe. What was a task of defining the parameters of “too big to fail” has become the challenge of figuring out what to do when important insolvent debtors are too large to save. There are many differences between the environment today and the environment in the autumn of 2008, or indeed at any other historical moment. But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.
To her very great credit Christine Lagarde, the new managing director of the International Monetary Fund, has already pointed up the three principles that any approach to Europe’s financial problems must respect. First, Europe must work backwards from a vision of where its monetary system will be several years hence. The reality is that Europe’s politicians have for the past decade dismissed the widespread view among experienced monetary economists that multiple sovereigns with independent budgeting and banking regulation will over time place unsustainable strains on a common currency. The European Monetary Union has been a classic case of the late economist Rudiger Dornbusch’s dictum: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” So it has been with the build-up of pressures on the eurozone system.
There can be no return to the pre-crisis status quo. It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance. It is equally clear that the risk of self-fulfilling confidence crises becomes substantial when banks and sovereigns have no access to lender of last resort financing. The responsibilities of the ECB, national financial and regulatory authorities and EU officials can be defined in different ways. But there must now be simultaneously an increase in the central financial commitment to the financial stability of member states, and a reduction in their financial autonomy, if the common currency is to survive.
Second, Ms Lagarde is right to point out serious issues of inadequate capital in European banks. Taking even relatively optimistic views about sovereign debt and growth prospects, European banks are in at least as problematic a condition as American banks were in the summer of 2008. Unfortunately, in many cases they are far larger relative to their national economies. Now is the time for realistic stress testing, and then resorting to private capital markets if possible, and to public capital infusions if necessary. With delay, private capital markets will close completely and nervous managements will rein in the provision of credit just when credit contraction is most likely to damage real economic prospects.
Third, like her predecessor, Ms. Lagarde has broken with IMF orthodoxy in noting that expansionary policies are necessary in the face of substantial economic slack. The oxymoronic doctrine of expansionary fiscal contraction is being discredited with every passing month. Europe needs a growth strategy. Yet almost everywhere, and certainly in the most indebted countries, binding commitments to eventual deficit reductions are a necessity. And in some places credibility has been lost to the point where immediate actions are needed. But Europe can handle its debts and contribute to a stronger global economy only if it grows. This will require both aggregate fiscal and monetary expansion.
This last point is an essential lesson of recent American experience. Even though credit spreads and equity values had normalised by the end of 2009, and the financial system was again functioning reasonably normally a year after the 2008 panic, lack of demand has continued to constrain growth. While any single household or nation can improve its balance sheet by saving more and spending less, the effort by all to cut back means reduced incomes and ultimately less saving for all. Germany, in particular, needs to recognise that if other European nations are going to borrow less then it will be able to lend less, and that as a matter of arithmetic this will mean a smaller trade surplus.
The world’s finance ministers and central bank governors will gather in Washington next weekend for their annual meetings. The meetings will have been a failure if a clearer way forward for Europe does not emerge. Remarkably, the European authorities that drove Ms Lagarde’s selection just three months ago have rejected important components of her analysis. In normal circumstances comity would require deference by others to European authorities on the resolution of European problems. Now, when these problems have the potential to disrupt growth around the world, all nations have an obligation to insist that Europe find a viable way forward. Failure would be yet another example of what Churchill called “want of foresight, unwillingness to act when action would be simple and effective, lack of clear thinking, confusion of counsel until the emergency comes, until self- preservation strikes its jarring gong – these are features which constitute the endless repetition of history”.
The writer is Charles W. Eliot University Professor at Harvard.
Copyright The Financial Times Limited 2012.